One of the more overlooked aspects of a good partnership/ownership agreement are provisions with respect to appraisals or valuation of the business. Valuation provisions are key because ownership interests are difficult to sell on the open market. As such, if the business is buying the ownership shares (either voluntarily or involuntarily), the partners/owner may end up in a vicious argument about price. To some, the valuation issue is simple. As an example, some might say that the business is “worth $100,000 and I have 10% ownership; therefore, my ownership share is worth $10,000.” However, business valuation is never that simple. First, the “value of the business” is often difficult to establish and there are differing methods. Second, there are premiums and discounts that are commonly placed on the value of ownership percentages depending on whether the percentage provides control of the business.

Aside from a voluntary or involuntary sale/buyout, there are other circumstances in which valuation is either necessary or useful including

Selling the whole business

Divorce or probate proceedings

Estate planning with respect to gifts and inheritances

Various potential litigation issues — such as proving damages to the business for business defamation or shareholder derivative litigation

Valuation needed for bank or other financing

Insurance-related valuations

And more

When drafting business valuation provisions, four aspects are key. First, as discussed above, it is crucial to decide and specify what is being appraised/valued — the business or the ownership percentage being sold? As noted above, with ownership interests, there are premiums and discounts applied to valuations that involve less than full ownership of the business. Second, the valuation provisions should delineate who pays for the appraisal — the selling owner, the business, or other? Third, the valuation provisions should identify which valuation method/methods is/are to be used. The standard methods are asset valuation, market or comparable valuation, and income valuation. Finally, the valuation provision should identify the method of dispute resolution. Binding and mandatory arbitration has become the newest trend since arbitration has the dual advantage of being less expensive and more final than traditional court litigation.

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Michael J. Leonard, Esq., is an award winning attorney whose practice focuses on corporate, securities, contract, and intellectual property law for small and medium businesses. In his practice, Mr. Leonard routinely assists his clients with the formation of business entities, financing through the sale of debt and equity securities, mergers and acquisitions, contract drafting and review including commercial leases, and establishment and licensing of trademarks, copyrights, and trade secrets.